Healthy Optimist

By

Neil A. Martin

March 17, 2003 12:01 a.m. ET

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An Interview with Frank Reichel - In the spring of 1999, as the high-tech stock boom was still crescendoing, fund manager Frank Reichel felt like a prophet without honor in his own country. Reichel, who then ran Plymouth Meeting, Pa.-based Stratton Small-Cap Value -- a little mutual fund that invested in small-company stocks he considered diamonds in the rough -- was preaching small-cap investing in a market that wasn't much in the mood to listen. "It was an interesting time," he recalls with obvious understatement. "Tech was hot and value, especially small-cap value, was not in favor. It was a hard sell," he admits, "but we never lost faith in the message."

Four years later, Reichel says, he feels vindicated.

In August 2000, he was hired by Thompson, Siegel & Walmsley, a Richmond, Va.-based investment adviser, to run its TS&W Small Cap Value Composite portfolios, launched in 1993 for the firm's institutional clients. TS&W is a subsidiary of South African insurer Old Mutual, and manages more than $4.4 billion.

Under Reichel's tutelage, Small-Cap Value Composite -- representing the aggregate performance of the firm's small-cap value accounts -- has enjoyed an annualized net return of 13.2%. In 2002, a year in which most small-cap funds had a loss, Reichel's composite produced a 0.3% return, 11.7 percentage points better than its benchmark.

Reichel, who recently returned from ski-paradise Telluride, Colo., where his family celebrated his father's 75th birthday, sees small caps leading the economy and the stock market out of the doldrums -- and thinks homeland-security-related and health-care issues may be the place to be for investors who believe a recovery is on the way. For details, read on.

Barron's:It wasn't long ago that small- cap funds were shutting down because they had reached the limits of their growth, and investment opportunities for fund managers were hard to find. What's the situation now?

Reichel: We did go through a period where there was so much money coming into small-cap funds that the managers had to close them to new investors. But -- given the negative cash flows in the mutual-funds industry of the past year, and the falling stock values in general -- the supply and demand situation has changed dramatically and a lot of small-cap value funds have reopened.

Q:So does that mean that now is a good time for investors to move back into small caps? A: We think so, especially if you're talking about small-cap value, which has done a good bit better than small growth and considerably better than large-caps. The latter group, as measured by the S&P 500, posted its third straight annual decline last year, falling 22.1%, and is down 14.5%, annually, over the past three years. While small-cap value stocks were not immune from the malaise of 2002 -- with the Russell 2000 Value index posting a drop of 11.4% -- they have outperformed all other groups, gaining an average of 7.4% per annum during the past three years.

Q:Even in this terrible market, there are still opportunities? A: In this market, there aren't many alternatives for the investor. With interest rates in the low single digits, we find it mathematically difficult to expect strong returns from the investment-grade bond market. And even though large U.S. stocks are down dramatically, valuation levels are far from their historical levels. We continue to believe that there are opportunities to generate solid returns by investing in small-cap stocks. Valuation levels remain attractive and this sector has historically led the market during times of economic recovery. Ibbotson data [see accompanying chart] show that small-cap value stocks have generated a 14.2% compound return over the 74 years ended in December 2000. Additionally, small-cap value has outperformed small-cap growth in six of the last seven decades and large- cap stocks in five of the last seven decades.

Q:You say small-cap stocks lead economies out of recessions. Why? A: One reason small-cap value funds have done so well over the past two years is because they have a higher percentage of their holdings in cyclical sectors of the market -- such as basic materials or producer durables -- than the S&P 500 or small-cap Russell 2000. This helps them outperform as the economy picks up. If you look at the period coming out of the 1974 recession, you'll see that it was one of the strongest times for small-cap value. So if the U.S. economy does manage to return to annual growth north of 3%, small-cap value will probably do very well.

Q:Although your composite has done well on a three-, five- and seven-year basis, you were flat last year. And going into 2003, you are down about 1%. What's this year shaping up to be?A: Given the level of uncertainty surrounding the current market, we would be hard-pressed to predict that we are going to have a very strong year in 2003. If we look at what's happened year-to-date through last February, the small-cap value index is probably down 6%, while we are down 5%. And, going forward, we think the next 12 to 24 months is probably going to be a low-return environment. So if we can add 1% to 2% above what is a high, single-digit, nominal return, that will be doing a lot for our shareholders.

Q:Would a war with Iraq help or hurt small-caps?A: In general, war is not good for stocks. That's especially true for the smaller part of the market that is less liquid, because people pay a liquidity premium to be able to get out of the market if something goes wrong.

Having said that, there are specific companies that do benefit from the ripple effects of a war economy, and one major theme in our portfolio is to focus on small companies that are benefiting from military mobilization or, more specifically, homeland defense.

Q:What companies are these? A: One example is
Flir Systems,
headquartered in Portland, Ore. It makes night-vision devices and surveillance systems used by government agencies -- such as the border patrol, police and fire departments and, of course, the military. Technology is making it cheaper for the armed forces to have more of these hand-held or helmet-mounted devices for night vision.

At 44 as I speak, Flir is currently trading around 18 times forward earnings and growing at an annual rate of 20%.

Q:What's another example? A: One of our largest holdings is
Engineered Support Systems Inc.
(acronym: ESSI), a military supplier of everything from shower modules to generators.

It has exposure to several areas of homeland defense, such as making electronics for surveillance planes, while one of its biggest businesses is making trailers for the transport and loading of tanks and other military equipment. It also produces filtered air systems and biological- and chemical- weapons-proof tent systems for air-tight, military command centers. It is growing at better than 20% a year and the stock is trading at a price-earnings ratio of less than 20. We think the outlook is very strong for ESSI, given its opportunity to participate in what the military needs in terms of a defensive, rapid-deployment capability.

Q:Generally, what kind of companies are you looking for? A: We try to find companies that have been beaten down by the market and that are cheap but not broken. We also want to make sure that we understand what are the drivers of their businesses. And, most important, we want to identify some catalyst that will help them recover and outperform their peers.

Q:How many stocks do you hold in your portfolio and in what sectors? A: We have about 65 stocks in our portfolio, with financials making up about 23% of our total holdings. The other big sectors are consumer discretionary (19%), materials and processing (14%), producer durables (10%), technology (9%) and health care (8%). But, because of the uncertain economic outlook, most of our larger sector overweights have been scaled back since last year.

Q:You were a little overweight in financials last year but now you are about 6%-to-7% below the level recommended by the Russell 2000 index. Why the cutback? A: We did very well with financials last year in the steep yield-curve environment, but we have since scaled back our holdings a bit because we believe the mortgage-loan business will slow down. But we still like the sector, as long as we can find banks that are doing something different than others or have found a profitable niche in the market like UCBH Holdings, a San Francisco-based financial institution that is providing small-business loans to the Asian-American community.

It is one of our largest holdings, and was up 50% last year. UCBH recently reported diluted earnings per share for 2002 that were 34% above year-earlier levels, marking the fifth consecutive year the company's profit growth has topped 25%. The stock is currently trading at about 17 times forward earnings. We like the company, although it's priced to perfection. It became too large in our portfolio and we had to trim it a little.

Q:Besides financials, you've also trimmed some of your holdings in the consumer sector. Why? A: The consumer discretionary sector was a significant plus for us last year -- when we believed that the consumers would continue to spend as they received extra money from home refinancings.

But in our current, sluggish economic environment, we are concerned about spending on big-ticket items like swimming pools, ATVs (all terrain vehicles), snowmobiles, motorcycles, and other recreational vehicles. So we have actually trimmed our position in many of these stocks.

We are worried that all types of retail sales might slow down as the refinancing boom comes to an end.

Q:Okay; so then in what areas have you increased your weighting? A: We are slightly overweight in technology, although we limit our focus to mature companies with recurring revenue growth as opposed to the new kids on the block trying to develop next- generation technologies.

Q:Who do you like there? A: One company in our portfolio is
MTS Systems,
located in Eden Prairie, Minn. The company makes testing and simulation systems and software that determine the mechanical behavior of materials, products, and structures. Its devices test and monitor all manners of things, including bridges, dams, motorcycles, airplane landing gear, prostheses and dental implants. It is one of a few major companies working on systems to test new car tires and recently signed up Bridgestone, which makes Firestone tires, as a major client which portends well for future business.

The stock is trading around 11, which is about 12 times 2003 expected earnings, and is growing annually at around 13%.

Q:What other sectors do you find attractive?A: We have also increased our holdings in the health-care sector, which we think will be a pretty attractive area in terms of earnings over the next few years. We have recently added two stocks that reflect our optimism about the sector.

One is
Respironics,
which primarily makes machines for adults suffering from sleep apnea, a disorder that [temporarily] stops people from breathing during sleep. Studies have indicated that as many as 1 in 10 American males, middle- aged to older, may be at risk for sleep apnea. Respironics is currently priced around 31 -- 17 times forward earnings -- and it's growing 18% a year.

The other is
Pharmaceutical Product Development,
which is a global drug-testing company that's a major beneficiary of new drug development. Its revenues have been growing north of 30% annually for the past five years. Despite concerns about spending cutbacks by the large pharmaceutical companies on new drugs, we believe PPD will enjoy top-of-the-line revenue growth north of 20% over the next two to three years. Insiders have been buying and the stock is currently trading below 20 times forward earnings.

Q:Since you say cyclical stocks are important to small-cap growth, what have you bought there recently? A: As I mentioned, we want companies in our portfolio that will benefit from economic recovery. One in that category we recently added is a transportation company,
Arkansas Best,
which has a strong position in the so-called "less-than-truck load" (LTL) business: These are companies that tend to service shorter routes and carry loads for more than one customer. Short-haul trucking firms are less affected by higher fuel prices than their long-haul peers, who also find themselves competing with the railroads for long-distance freight business.

The LTL industry is also shrinking, as underscored by the recent demise of Consolidated Freightways. That's increasing margins for the remaining three or four players like Arkansas Best. ABFS is trading around 23, which is about nine times the $2.50 per share we think it will earn this year, with a further earnings increase expected next year.

Q:You own a specialty paper company, Schweitzer-Mauduit International. What's the story there?A:Schweitzer-Mauduit International
is an Alpharetta, Ga.-based company that makes cigarette paper and reconstituted tobacco products.

They've recently developed a new brand of cigarette paper that burns with low flammability -- that reduces the risk of starting fires in beds or on sofas. Some state legislatures, including New York's and Rhode Island's, are considering mandating this kind of paper in tobacco products.

The company is also benefiting from one of their cigarette-paper competitors' going out of business -- which helps reduce competition. We think that this is a very interesting story, especially for a stock that is trading at 10 times the $2.35-$2.40 it is expected to earn this year.

Q:What prompts a sell? A: If a company disappoints on earnings, we will have to decide whether to reduce our holdings -- or to eliminate it entirely.

In the case of
J.Jill Group,
a women's clothing retailer that sells merchandise online and through a mail-order catalogue, it was the latter. Last year, the company warned that its earnings would be hurt by an unseasonably warm winter nationwide which was undercutting their expectations that a cold winter would increase sales of heavy clothing like sweaters, so we decided to sell it.

We bought the stock originally in April of 2001 at around 12 and held it as high as 30, but sold it last December when it started heading down toward 13. The stock currently trades around 10.

Q:Any other recent sells? A: We sold
Nash Finch,
a wholesale food distributor, in the final quarter of 2002. Since first delaying their earnings report last October, they have been plagued by ongoing accounting issues.

We took a 30% loss, but the stock is now 60% below where we sold it. The company has strong cash flows and still has a good business if it doesn't lose too many clients during this current period of uncertainty.

We are negative about
Research in Motion,
which has a terrific product -- the Blackberry personal digital assistant -- but is not making money because of a soft, very competitive market and it probably will not earn any money until 2004.

And we'd pass on
RF Micro Devices,
which makes semiconductor components for cellular-handset manufacturers. The company has targeted China as one of its main growth areas, but the country is starting slowly and inventories are twice their normal levels.

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